Sunday, November 2, 2008

Don't Blame Me, I Voted For Henry Clay

One of the most vociferous critics of the American fiscal policies that have brought about the current global financial crisis has been Peer Steinbrück, the German Finance Minister. In several widely-reported interviews, Steinbrück blamed the financial crisis on America’s highly-unregulated financial system, stating that the collapse of this system would result in the end of America’s status as the world’s financial superpower. http://www.ft.com/cms/s/0/a8ab34ea-8b63-11dd-b634-0000779fd18c.html Steinbrück and other European finance ministers particularly recalled last year’s G-7 meeting, at which German Chancellor Angela Merkel urged the US and the UK to adopt more intensive regulation of hedge funds, emphasizing the need for America to move away from its bifurcated banking system that distinguishes between commercial banking and investment banking, and to move toward a more integrated regulatory framework similar to the one generally following in Continental Europe, and indeed, in most of the rest of the world. American representatives at that G-7 meeting generally scoffed at the proposal as a “typical example of Germans’ penchant for over-regulation”, stating that it was not “America’s way.” Steinbrück’s recent criticism of the American financial system had more than a bit of schadenfreude and a refrain of “I told you so.”

In the days following Steinbrück’s jeremiad against the American financial system, the Germans and many other continental Europeans have found themselves wearing a good deal of egg on their faces, as the financial crisis has spread throughout Europe – effectively wiping out the economy of one European nation, Iceland – and it has become clear that European financial institutions have been as guilty as their American counterparts in engaging in foolish speculative activities that have endangered the global financial system. Indeed, Steinbrück and other Europeans have spoken with considerable admiration for the aggressiveness with which US Treasury Secretary Paulson has confronted the crisis, successfully overcoming Congressional opposition on the Left and the Right in order to enact an impressive program authorizing broad government intervention in the financial markets.

At heart, however, there is a good deal of truth in the German criticism of the American financial system. Banking in America, and the American legal and regulatory scheme governing the banking industry, is quite different from the rest of the world. In some respects, America’s unique banking system has been beneficial, helping to fuel the rapid economic growth that has been the hallmark of American history. However, the American banking system has also been very prone to financial “panics” – bursts of extreme financial instability – which have often been the harbinger of wider periods of economic recession and depression. In today’s world of capitalist globalization, it is very dangerous for America’s banking system to continue playing the role of the world's financial “maverick”, as its proclivity for financial instability can rapidly lead to worldwide economic crises.

America often reminds me of Madagascar. Evolutionary biologists love to study Madagascar because it has numerous species of plants and animals that are found nowhere else in the world. However, because Madagascar is an island that broke off from the African mainland in relatively recent geological time, it is possible to find common ancestors that link species found in Madagascar to those found in the rest of Africa. For example, lemurs are unique to Madagascar. They are primates that share common ancestors with the monkeys, apes and humans that evolved in Africa. However, lemurs went off in their own evolutionary direction on the isolated island of Madagascar.

Like Madagascar, America has evolved institutions that are often quite different from those in the rest of the world. America is one of the few countries in the world that is not metric; it is virtually the only country that does not have a VAT (a pet peeve of mine that I will write about some day). The American legal system has lots of rules that are unique – American civil juries have no analog in other countries and the American system of civil litigation, with its free-wheeling discovery, general lack of judicial supervision, and potential for generating enormous jury verdicts including punitive damages, is unlike any other legal system in the world. And, as the Germans have recently pointed out, the American banking system is different from the rest of the world.

Again, the analogy to Madagascar strikes me as very apt. Many of these unique American institutions can be traced to antecedents in Europe, primarily England, such as the jury system or the English system of measurement. However, because of its physical and political isolation, these institutions took a different evolutionary course in America.

To understand America’s unique banking system, we have to go back to the Presidency of Andrew Jackson. As readers of this blog may have noticed, I am quite prone to find the influence of “Jacksonian” ideology in many aspects of American life. The “Jacksonian Era” was the area of my concentration as an American History major in college, and, as I have often commented, I consider Walter Russell Mead’s essay, “The Jacksonian Tradition”, to be one of the most insightful pieces ever written about American ideology. The recent debate on the so-called “Wall Street bailout” had a very familiar ring to anyone who has studied the rhetoric of Jacksonian America. “Populists” on both the Right and the Left decried the greed and corruption of “Wall Street”, in contrast to the honesty and common decency of “Main Street.” These speeches could have been delivered almost verbatim in the 1820s, and they would have been completely comprehensible to the partisans of that era. So, in order to understand the world's current financial crisis, a journey into history is in order.

Modern banking got its start in the Dutch Republic in the late Sixteenth and early Seventeenth Centuries. There were a number of factors that caused Holland to become the first center of merchant capitalism. The Protestant Reformation broke down traditional Roman Catholic dogma that viewed all forms of money lending as sinful. Muslim and Jewish emigrants to the Netherlands fleeing the Spanish Inquisition brought with them an entrepreneurial culture and an understanding of the potential benefits of credit, that embodied the germs of a nascent financial system. The European discovery of the Americas and the beginnings of industrial capitalism promoted trade and sea travel, all of which was very expensive and could not take place without a system of credit. The Dutch golden age proved to the world that there was nothing inherently evil about credit and debt, and that an economy based on merchant capitalism, financed by credit, could generate hitherto unimagined levels of general wealth, and notably, a degree of wealth not restricted to the aristocracy but increasingly available to a new phenomenon in human history: a growing mass middle class.

By the end of the Seventeenth Century, Britain replaced Holland as the dominant merchant capitalist power in the world. The British, however, learned an important lesson from the Dutch about managing an economy based on credit. While credit can be an extremely powerful force in promoting general prosperity, it can also be a very dangerous force if not managed wisely. A credit-based economy can be highly unstable, a characteristic that often spills over into the social and political spheres; Kevin Phillips’s work American Theocracy describes the tendency of societies that are excessively reliant upon credit to experience highly disruptive and often contradictory social phenomena, such as moral decadence and religious fanaticism.

In an effort to manage a credit-based economy more wisely than the Dutch had done, Britain developed a system of central banking. The Bank of England oversaw the activities of all lesser banks. The British modification of the Dutch financial system proved to be fabulously successful, as British trade came to dominate the world. The British were able to convert their mastery of the world’s financial system into political and military dominance, as the British victory in the Seven Years’ War confirmed Britain’s status as the dominant global power, a position it would hold for almost two-hundred years.

One of the most ardent admirers of the British system of central banking was America’s first Treasury Secretary, Alexander Hamilton. At Hamilton’s urging, President Washington supported the establishment of the First Bank of the United States, an institution modeled directly on the Bank of England. The Bank of the United States would serve as the repository of all revenues of the Federal government. This control over Federal revenues would give the Bank a position of dominance in the American financial system that would enable it to exercise direct control over the credit policies of all subordinate banks. Hamilton's system was very popular in the Northeast, especially New York and New England, where merchants and infant industrialists benefited from the fact the Bank gave credibility to the new American Dollar and established stability in credit markets. The agrarian South was less interested in credit, and Hamilton's Bank conflicted with the Jeffersonian ideology that favored "small government" and a society of "yeoman farmers", and distrusted trade and finance.

In 1811, Jefferson's successor, President James Madison, allowed the charter of the Bank of the United States to lapse. Madison, however, soon learned an important lesson in the importance of having a sound financial system. In 1812, Madison succumbed to pressure from the "war hawks" and picked a fight with England, the world's financial superpower. While the over-confident Americans were embarrassed during the early stages of the war - including the British capture of Washington, DC and the burning of the White House - the young American Republic did manage to eke out a draw. The financial consequences of the war, however, were devastating. Madison's Treasury Secretary, the Swiss-born Albert Gallatin, persuaded Madison to revive the Hamiltonian system of central banking and the Second Bank of the US was established in 1816.

Nicholas Biddle, the President of the Second Bank, was, by most accounts, a pretty obnoxious and corrupt individual. Biddle unabashedly used the economic power of the Bank to advance political ends. The two politicians who would later become the founders of the Whig Party, Daniel Webster and Henry Clay, were virtually hired hands of the Bank. Webster served as the Bank's principal lawyer, arguing on behalf of the Bank in the landmark Supreme Court case of McCulloch v. Maryland. Clay served as the Bank's principal agent in Washington, making liberal use of the Bank's economic power to provide benefits to politicians who worked with Clay to advance Biddle's fortunes. Nevertheless, in spite of his corrupt propensities, Biddle was an effective banker and the Second Bank succeeded in bringing about a prolonged period of prosperity and economic stability during the 1820s.

Andrew Jackson was elected President in 1828, and populist rhetoric directed against the Bank became a maninstay of his political agenda. The Bank was attacked as "aristocratic", and Biddle's abuse of the Bank's economic power as a means of extending his political influence made him a worthy target of much of this criticism. Jackson's attack on the Bank also carried an ethnic dimension. Jackson drew strong support among Scots-Irish immigrants, who had come to the US in large numbers in the years following the Revolution, and the Bank was targeted as an "English" type of institution, and Biddle and his supporters were pilloried as Anglophiles.

Jackson easily defeated the pro-Bank candidate Clay in the election of 1832. Getting rid of the Bank was the top priority of Jackson's second term. Not content to wait for the Bank's charter to lapse, Jackson set about to achieve his goal of the immediate destruction of the Bank. Jackson directed the Secretary of the Treasury to withdraw all Federal funds from the Bank and transfer the funds to various state-chartered banks that were run by Jackson's political supporters. Several Treasury Secretaries resigned rather than follow Jackson's order, which was of doubtful legality. Ultimately, Jackson designated his Attorney General and longtime political crony, Roger Taney, as the Secretary of the Treasury, and Taney carried out Jackson's directions. Soon thereafter, Jackson would reward the toady Taney by appointing him to succeed John Marshall as Chief Justice of the Supreme Court, where Taney would achieve notoriety and would again have an opportunity to change the course of American history, and not for the better, by writing the majority decision in the infamous Dred Scott case.

Stripped of its status as the sole repository of Federal revenues, the Second Bank withered away as an institution of importance in the American economy, and became irrelevant by the time its charter lapsed. The imperious Biddle endured a similar fate.

It is noteworthy that Jackson's attitude towards banking and credit differed significantly from that of the Jeffersonians. Jackson had no particular antipathy towards banks and a credit-driven economy, quite the contrary. Jackson's principal objection to the Bank had been based on its political power and its support for Jackson's rivals. Jackson also objected to the fact that the Bank of the United States tended to impede the growth of numerous state-chartered banks; again, many of these banks were owned by Jackson's political supporters. With the abolition of the Second Bank, there was in fact an explosion in both the number and the size of state-chartered banks. Without any central bank to place any controls on the activities of the state-chartered banks, and with little regulation being imposed by the highly corrupt state governments that chartered these banks, speculation of all sorts ran rampant throughout the American economy. This resulted in the Panic of 1837, initiating a period of serious economic dislocation. By this time, however, Jackson had left the White House and it was his successor, Van Buren, who would pay the price for this economic collapse, being defeated in 1840 by Whig candidate William Henry Harrison, who co-opted the same pseudo populist rhetoric that was Jackson's stock in trade.

Notwithstanding the unhappy experience of the Panic of 1837 and subsequent economic collapse, the American system of state-chartered, minimally-regulated banking instituted by Jackson remained largely unchanged for almost a century. The National Banking Act, enacted during the Civil War, established the Office of the Comptroller of the Currency to provide some minimal level of Federal oversight, but for the most part, no major changes occurred in the system. The most important changes in the American banking system during the Nineteenth Century occurred not because of new legislation or governmental regulation, but rather, because of changes within American society and the American economy. Specifically, the uniquely American bifurcation between commercial and investment banking began to take shape.

What we would ultimately call “commercial banking” came under the domination of J.P. Morgan. Morgan acted as the conduit for large amounts of foreign investment into the U.S., primarily from England. However, the minimally-regulated Jacksonian banking system made it possible for other tycoons to translate their wealth into financial clout. Oil magnates such as Mellon and Rockefeller transformed themselves into bankers. John D. Rockefeller bought up control of the Chase National Bank; brother William Rockefeller took over the First National City Bank, today’s Citibank.

Meanwhile, American ethnic divisions gave birth to a separate, much riskier branch of the banking industry, originally known as “merchant banking” and now known as “investment banking”. German Jewish financiers such as August Belmont (née “Schönburg”), Joseph Seligman, Jacob Schiff, and Marcus Goldman gave birth to the great investment banking firms of Wall Street. These financiers were locked out the world of mainstream banking by Morgan and other WASPs, but they compensated for the impact of such discrimination by opening doors for investments into the American economy by European Jewish financiers such as the Rothschilds and the Warburgs. (Stephen Birmingham’s brilliant work Our Crowd is an outstanding history of the great German Jewish families of New York who played a major role in establishing the leading investment banking firms and inventing “Wall Street.”)

This free-wheeling, unregulated system of commercial and investment banking fostered the smooth flow of capital into the American economy, leading to an era of economic growth in the U.S. virtually without precedent in human history. However, the system was prone to repeated financial “panics”, with increasingly destructive effects on the American economy. In order to mitigate the impact of these frequent disruptions to the American financial system, Morgan began to assume the role of a de facto central bank. During the Panic of 1907, Morgan did many of the same things Secretary Paulson proposed doing to deal with the current crisis. Morgan’s efforts proved to be extremely effective, mitigating significantly the economic impact of the 1907 financial crisis.

Morgan’s death in 1913 made it clear that something had to be done to bring some order to the American banking system. As a result, Congress created the Federal Reserve system.

While we often think of the Federal Reserve as the American central bank, it really isn’t one in the sense that central banks exist in most countries of the world, or in the sense of the Bank of the United States as it existed before Jackson did it in. The Federal Reserve has virtually no regulatory authority or capability with respect to the banking system as a whole. The Federal Reserve’s job is to regulate the size of the money supply, by setting the discount rate at which member banks borrow money and by buying or selling government bonds in order to either inject or withdraw funds from the banking system. What the member banks do with the money is, for the most part, not something that the Federal Reserve has any control over.

The minimally-regulated American banking system again helped to spur massive economic growth during the 1920s, as the historic distinctions between commercial and investment banking virtually disappeared and the large amounts of funds available to commercial banks flowed into highly-risky new investment ventures. As a result, the stock market soared to new heights. Also as a result, when the inevitable fall came, as it did in 1929, it was more catastrophic for the economy as a whole than any of the prior panics that had frequently rocked the American financial system.

One of the first pieces of legislation enacted during the New Deal was the Glass-Steagall Act of 1933. The principal author of the law, Senator Carter Glass of Virginia, was an extremely conservative legislator, and he had no desire to overturn the fundamentals of the American financial system. The law responded to the financial crisis not by creating a real central bank or by establishing a comprehensive regulatory scheme over all aspects of the financial industry, but rather, by creating a wall of separation between commercial banking and investment banking. In other words, the Glass-Steagall Act codified into law the separation between commercial and investment banking that had long existed in the American financial system. Commercial banking would enjoy the benefit of insured deposits through the creation of the Federal Deposit Insurance Corporation, but at the same time, commercial banks would be sharply restricted in the kinds of investments they could make. Specifically, commercial banks would be barred from making investments in equity.

The wall of separation created by the Glass-Steagall Act left the highly profitable equity markets as the exclusive preserve of investment banking firms. The Securities Act of 1933 and the Securities Exchange Act of 1934 imposed new disclosure requirements on equity markets, but in many ways, the business of investment banking continued to be highly unregulated and very risky. And for the firms that managed to succeed in the risky business of investment banking, the business was extraordinarily profitable.

The end of World War II and the subsequent Bretton Woods agreements left the United States as the world’s economic superpower. American financial institutions – both commercial banks and investment banks – prospered. By the 1970s, however, the Bretton Woods regime had broken down and capitalist globalization was on the march. By the 1980s, European and Japanese financial institutions had become dominant and few American banks made it into the lists of the world’s largest financial institutions.

The Glass-Steagall Act became a major target of lobbying by American commercial banks. The exclusion of American commercial banks from the highly profitable business of investment banking, an exclusion that did not apply to non-American financial institutions, was portrayed as a major drag on the competitiveness of American banks.

An attempt to make an end-run around the restrictions of the Glass-Steagall Act was made during the 1980s through the creation of equity-like debt instruments colloquially known as “junk bonds.” This experiment resulted in the savings and loan debacle and a consequent bloodbath for federal insurance, accompanied by the financial crisis of the late 1980s and the recession of the early 1990s.

Lobbying against Glass-Steagall by the commercial banks continued during the 1990s, and it began to get real traction when the Republicans gained control of Congress in 1994. The Gramm-Leach-Bliley Act of 1999 finally repealed almost all of what was left of Glass-Steagall.

What seems to have been forgotten when Gramm-Leach-Bliley was enacted was the fact that at its core, America continued to have the same minimally-regulated financial system that resulted from Jackson’s abolition of the Bank of the United States in 1833. Without Glass-Steagall to stop the spillover of the risky business of investment banking into commercial banking, there was little regulatory framework in place to ensure the stability of the American financial system. Not surprisingly, the financial activities of the past decade bear remarkable similarities to the pre-Glass-Steagall era of the 1920s. The commercial banks would move aggressively into investment banking. More importantly, new institutions that would be largely immune from the regulatory jurisdiction of the securities laws, hedge funds, and new financial instruments also largely outside of the jurisdiction of the securities laws, derivatives, came to play dominant roles in the financial industry. As a result, again, when the inevitable collapse came it caused a massive impact on the American economy. And because we now have a truly globalized economy, the effects of the collapse have been felt in every corner of the globe.

Where do we go from here? It seems clear to me that the American tradition of a minimally-regulated financial industry cannot be sustained. On the other hand, there is some legitimacy to the criticism of over-regulation in many European countries such as Germany. The free flow of capital is more important than ever in the era of globalization. The nascent capitalist boom in countries such as China, India, Brazil, Russia, etc., must be sustained in the interest of global economic and political stability. Overreaction in regulating the financial industry could have very harmful effects in choking off economic growth in these emerging economies.

My view is that this is a time for synthesis. I would, of course, like to see the establishment of a new Bretton Woods regime for the 21st Century. However, this should not lead to the creation of some new global central bank to impose an extensive regulatory scheme on all of the financial institutions of the world. Rather, I would foresee the new global regime as imposing certain minimal regulatory standards that the major nations of the world would impose on their financial institutions. The era of unregulated Jacksonian banking should end. However, it also seems that the world could learn something from the American experience under the Glass-Steagall act. Different levels of regulation may be appropriate for different types of financial activities. Risky forms of investment should not be discouraged by overreaction and over-regulation, but on the other hand, the inevitable losses resulting from such speculative investment activities should have limited ramifications, so as to avoid the kinds of massive, global financial collapses we have seen in 1929 and 2008.

The real bottom line is that America can no longer be Madagascar. The rest of the world can learn a lot from the unique American evolutionary history. But neither America nor the rest of the world can afford to have America continue to be the global financial “maverick”, maintaining the Jacksonian model of an unregulated financial industry whose inevitable failures rock the foundations of the world’s economy. In other words, it’s time to re-do the election of 1832.